The Capitulation Bottom

One of the biggest ironies (among many) in the realm of financial speculation is that major bottoms in all markets are a direct consequence of the massive amount of sell orders that flood the exchange when most market participants finally reach their breaking point. This breaking point, or as it’s commonly referred to in the financial markets, “capitulation” —which Webster’s Dictionary defines as the act of surrendering or yielding — happens with a very strong bout of selling. This panic type selling is usually induced when very bad news hits the news wires. To the unwitting market participant, this seems counter intuitive, as you would think that all of that selling would send the markets much lower, but the fact is that quite often a strong bounce usually ensues immediately after all the exhaustive selling is done. Think about the last time you sold out in a panic, only to see the market rebound sharply. Emotions also play a big part in this “capitulation” bottoming pattern.

Along the same lines, another event that triggers outsized selling in more of a technical nature is when big hedge funds take on too much leverage. This happens when the markets are going up and they continue to add to their positions. When the market finally turns, these positions have to be unwound and, often times, a margin call forces the broker to liquidate all or part of their position to meet the obligation.

So how do we turn this into opportunity? Knowing the outcome of this phenomena is a good start. Last weekend we saw this scenario play out in the gold market. As the Gold futures opened Sunday evening it traded quietly, going sideways for the first two hours and then quite suddenly sold off 50 dollars in about 10 minutes. This price shock rattled a few nerves, I’m sure. And not to mention a few stops suffered a few ticks of slippage. Very quickly, however, it then bounced 30 dollars in the next hour. In the chart below we can see how it all unfolded.

After this type of move, what typically happens is the lows are tested or sometimes breached; this is where we find out if it’s a true bottom. In other words, the lows around 1080 in the gold futures should be tested or maybe even slightly violated in the next several weeks. When this happens, the key is that price holds and turns quickly. If that’s the case, the probability that the intermediate term low is in place is very high. Notice I said probability. I say that because nobody knows for sure what will happen next. It’s all about increasing the odds and managing risk in this business.

The actual trade comes from new levels of demand forming near the lows. When you think about it rationally, if the sellers have been exhausted then what should happen next is new buyers (coupled with short covering) should drive the market higher. As traders we have to find the picture that represents those unfilled buy orders, then take action.

In the final analysis, the markets are always throwing off clues that indicate when the tops or bottoms are at hand. We, as traders, have to look at the information objectively and distinguish between illusion and opportunity. To do that takes learning how the markets really work because… what’s the alternative…?

Until next time, I hope everyone has a great week.

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